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Dead Precedents

Born in 1819, Herman Melville was by all accounts a quiet and unassuming man. He wrote several books but the most famous was Moby Dick, written largely based on his experiences as a whaler in 1840. The book was a great success. 

Since his death, however, some have chosen to read hidden messages in the book that, according to them, foretold of future tragedies such as the assassinations of Indira Gandhi, Leon Trotsky, Reverend Martin Luther King, John F Kennedy, Abraham Lincoln, Yitzhak Rabin and even Princess Diana*.

Not bad for a book on whales.
The serious point, however, is that the human brain eagerly looks for patterns in almost anything. Unfortunately this often means that it looks for patterns in meaningless or random data, a tendency known as apophenia. This explains how people ‘see’ faces in the patterns of rocks on the Moon or images of Christ on burnt pieces of toast.

Investments involve the assimilation of data to create credible and reasoned recommendations in a complex adaptive system. There is a considerable amount of noise, especially from the media that need to fill the 24 hour news cycle, and the investment banks with their vested interests.  In the investment world, however, apophenia only serves to increase the noise to signal ratio.
Take technical analysis, for instance. A large section of the investment community is involved in drawing lines on graphs to try and identify levels where assets may be over or undervalued on the basis of the maximum, minimum and interim trends that the asset has moved in the past.  Some of it may be credible but there is a large leap of faith in using this analysis in believing that what happened in the past will be repeated in the future.
Here, try it yourself. Look at the chart below. Over the next few years, is it going up or falling further?

You may think it is fallen enough and is due to bounce back up or you may think has further to fall to previous lows.

The truth is nobody knows – the reason being that this chart has been generated using random numbers (specifically, random numbers with a mean of zero and standard deviation of 0.5) and there is as much chance of it rising, falling or remaining where it is.

At Equilibrium, we understand the concept of reversion to the mean which means that data will often move towards long term average levels.  Equally, we understand the dangers of believing “this time is different” (often quoted in markets during the technology bubble around 1999).

The danger is calling it a top or a bottom. Using historic numbers to say ‘it’s a buy at X’ or ’it’s a sell at Y’ based on the fact it happened last time can get you into a lot of trouble.

For a start, it may be different this time around.  Perhaps not for some markets but certainly companies can fundamentally change in nature.  Dull, sleepy corporations have been known to transform into efficient, high growth enterprises with the right management and market conditions.

Secondly, as John Maynard Keynes once observed, “the market can stay irrational a lot longer than you can stay solvent”.  He should know - although the famous British economist was a keen private investor and also very successfully managed the funds for King’s College, Cambridge, he was almost wiped out by the Wall Street Crash of 1929.  This tendency for markets to overshoot when markets are expensive and continue to fall when they are cheap has consistently caught investors out.

At Equilibrium, we invest when the odds are in our favour and use evidence-based metrics to determine when those probabilities will make our clients’ money or avoid losing it. Of course, we are not always going to get it right but at least decisions are made on rational basis rather than some figment of our imagination.

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